Chesapeake and Post-Production Costs

Lawsuits against Chesapeake Exploration for wrongfully deducting post-production costs from its gas royalty payments are hitting a boiling-point. Suits are being pursued against the company in every jurisdiction where it operates, including Texas, Arkansas, Lousiana, Kansas, Ohio, West Virginia, Oklahoma and Pennsylvania. Chesapeake has recently been much more aggressive in deducting post-production costs. In the Barnett Shale in North Texas, its post-production cost deductions have been as much as $.70 to $1.00 per mcf, and with such low gas prices, some royalty owners’ payments have been halved by such deductions. Chesapeake’s royalty payments in North Texas have reportedly been on a net price of as little as eleven cents per mcf, and as little as 11% of the price other producers have based their royalty payments on. A recent Bloomberg article summarizes Chesapeake’s royalty payment practices.

Chesapeake’s tactics for how it calculates its royalties cannot be understood without knowing something about how Texas courts have addressed deductibility of post-production costs. I have previously written three posts on this topic that can be seen here, here and here.

Oil company oil and gas lease forms historically have provided that royalties on natural gas are based on “market value at the well” or the “net amount realized at the well.” Texas courts have construed such leases to allow the producer to deduct from gas sale proceeds the costs of gathering, transporting, treating and processing gas after it has been produced but prior to sale. In response, mineral owners in Texas began adding “no-deduction” clauses to their leases, prohibiting deduction of such costs for purposes of calculating their royalty. One such clause from a famous Texas Supreme Court case, Heritage Resources v. Nationsbank, 939 S.W.2d 118 (Tex. 1996), said: “provided, however, that there shall be no deductions from the value of the Lessor’s royalty by reason of any required processing, cost of dehydration, compression, transportation or other matter to market such gas.” To most oil and gas attorneys’ suprise, the Supreme Court in Heritage v. Nationsbank held that, despite this no-deduction clause, Heritage Resources was entitled to deduct transportation costs from Nationsbank’s royalty. The court reasoned that, because the lease provided that royalty would be based on the “market value at the well” of the gas, no deductions were being made from that value in calcluating Nationsbank’s royalty. The Supreme Court deemed the no-deduction language to be “surplusage.”

Since Heritage v. Nationsbank, landowners have begun to include language in their leases expressly stating that their lease should not be construed like the lease in Heritage. But despite such efforts, Chesapeake has relied on the Heritage case to continue deducting post-production costs from its royalty payments.

Two Texas cases challenging Chesapeake’s right to deduct post-production costs are now on appeal to the U.S. Court of Appeals for the Fifth Circuit, both appealed from the U.S. District Court in Dallas: Potts v. Chesapeake, Case No. 13-1061, appealed from the U.S. District Court in Dallas; and Warren v. Chesapeake, District Court No. 3:12-cv-03581-M. In both cases, Chesapeake won in the trial court and the royalty owners are appealing.

The cases reveal that, in the Barnett Shale, Chesapeake sells its gas to its wholly-owned subsidiary, Chesapeake Energy Marketing Inc. (CEMI). The sales contract provides that CEMI takes custody of the gas at the wellhead. CEMI then gathers the gas and sells it to various purchasers at various prices. The Chesapeake-CEMI contract provides that the price paid to Chesapeake for the gas will be the weighted-average sales price of all gas sold by CEMI from Chesapeake wells in the area, less post-production costs incurred by CEMI. By structuring its sales through its affiliate and providing for the contract point of delivery to be at the wellhead, Chesapeake seeks to take advantage of its leases that provide for royalties based on “market value at the well,” as construed by Heritage v. Nationsbank.

The oil and gas lease construed in Warren v. Chesapeake appears to fall squarely within the Heritage holding: it provides for royalty based on “the amount realized by Lessee, computed at the mouth of the well.” A provision added by the landowner states:

Notwithstanding anything to the contrary herein contained, all royalty paid to Lessor shall be free of all costs and expenses related to the exploration, production and marketing of oil and gas production from the lease including, but not limited to, costs of compression, dehydration, treatment and transportation. Lessor will, however, bear a proportionate part of all those expenses imposed upon Lessee by its gas sale contract to the extent incurred subsequent to those that are obligations of Lessee.

The lease construed in Potts v. Chesapeake is much more interesting, and presents a closer case. Its language is contained in two paragraphs. The first provides that royalty shall be based on the “market value at the point of sale,” and that “all royalty paid to [Lessors] shall be free of all costs and expenses related to the exploration, production and marketing of oil and gas produced from the lease including, but not limited to, costs of compression, dehydration, treatment and transportation.” A separate paragraph provides that “Payments of royalties to Lessor shall be made monthly and shall be based on sales of leased substances to unrelated third parties at prices arrived at through arms length negotiations.”

The plaintiff in Potts argues that his lease is not controlled by Heritage v. Nationsbank; his royalties are to be based on the price “at the point of sale,” not “at the well”; and his royalties must be based on the sale price to unrelated parties arrived at in arms-length negotiations, not the price in the Chesapeake contract with its affiliate CEMI.

Chesapeake argues that it has complied with both lease provisions. First, since it sells its gas at the well, the “market value at the point of sale” is the same as the “market value at the well,” so it is in compliance with the first lease provision in paying based on the price it receives from CEMI. Second, because the price CEMI pays Chesapeake for the gas is based on the weighted-average price for CEMI’s sales of gas to unrelated parties in arms-length transactions, it is complying with the second lease provision.

It seems clear that the landowner in Potts was attempting to draft his lease to prevent deduction of post-production costs and to require that his royalties be based on the price received in the first arms-length sale of his gas. Whether he accomplished that intent is a matter for the Fifth Circuit Court to decide.

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